May 7, 2013

Foreign
exchange brokers, unlike equity brokers, do not take positions for themselves;
they only service banks. Their roles are:

• bringing together buyers and
sellers in the market;

• optimizing the price they show to
their customers;

• quickly, accurately, and
faithfully executing the traders' orders.

The
majority of the foreign exchange brokers executes business via phone. The phone
lines between brokers and banks are dedicated, or direct, and are usually installed
free of charge by the broker. A foreign exchange brokerage firm has direct
lines to banks around the world. Most foreign exchange is executed through an
open box system—a microphone in front of the broker that continuously transmits
everything he or she says on the direct phone lines to the speaker boxes in the
banks. This way, all banks can hear all the deals being executed. Because of
the open box system used by brokers, a trader is able to hear all prices
quoted; whether the bid was hit or the offer taken; and the following price.
What the trader will not be able to hear is the amounts of particular bids and
offers and the names of the banks showing the prices. Prices are anonymous the
anonymity of the banks that are trading in the market ensures the market's
efficiency, as all banks have a fair chance to trade.

Brokers
charge a commission that is paid equally by the buyer and the seller. The fees
are negotiated on an individual basis by the bank and the brokerage firm. Brokers
show their customers the prices made by other customers either two-way (bid and
offer) prices or one way (bid or offer) prices from his or her customers.
Traders show different prices because they "read" the market differently;
they have different expectations and different interests. A broker who has more
than one price on one or both sides will automatically optimize the price. In
other words, the broker will always show the highest bid and the lowest offer.
Therefore, the market has access to the narrowest spread possible.

Fundamental
and technical analyses are used for forecasting the future direction of the
currency. A trader might test the market by hitting a bid for a small amount to
see if there is any reaction. Brokers cannot be forced into taking a principal
role if the name switch takes longer than anticipated. Another advantage of the
brokers' market is that brokers might provide a broader selection of banks to
their customers. Some European and Asian banks have overnight desks so their
orders are usually placed with brokers who can deal with the American banks,
adding to the liquidity of the market.

Direct Dealing

Direct
dealing is based on trading reciprocity. A market maker—the bank making or
quoting a price—expects the bank that is calling to reciprocate with respect to
making a price when called upon. Direct dealing provides more trading discretion,
as compared to dealing in the brokers' market. Sometimes traders take advantage
of this characteristic. Direct dealing used to be conducted mostly on the
phone. Dealing errors were difficult to prove and even more difficult to
settle. In order to increase dealing safety, most banks tapped the phone lines
on which trading was conducted. This measure was helpful in recording all the
transaction details and enabling the dealers to allocate the responsibility for
errors fairly. But tape recorders were unable to prevent trading errors. Direct
dealing was forever changed in the mid - 1980s, by the introduction of dealing
systems.

Dealing Systems

Dealing
systems are on-line computers that link the contributing banks around the world
on a one-on-one basis. The performance of dealing systems is characterized by
speed, reliability, and safety. Accessing a bank through a dealing system is
much faster than making a phone call. Dealing systems are continuously being
improved in order to offer maximum support to the dealer's main function:
trading. The software is very reliable in picking up the big figure of the
exchange rates and the standard value dates. In addition, it is extremely precise
and fast in contacting other parties, switching between conversations, and accessing
the database. The trader is in continuous visual contact with the information
exchanged on the monitor. It is easier to see than hear this information,
especially when switching between conversations.

Most
banks use a combination of brokers and direct dealing systems. Both approaches
reach the same banks, but not the same parties, because corporations, for
instance, cannot deal with the brokers' market. Traders develop personal
relationships with both brokers and traders in the markets, but select their
trading medium based on price quality, not on personal feelings. The market share
between dealing systems and brokers fluctuates based on market conditions. Fast
market conditions are beneficial to dealing systems, whereas regular market
conditions are more beneficial to brokers.

Matching Systems

Unlike
dealing systems, on which trading is not anonymous and is conducted on a
one-on-one basis, matching systems are anonymous and individual traders deal
against the rest of the market, similar to dealing in the brokers' market.
However, unlike the brokers' market, there are no individuals to bring the prices
to the market, and liquidity may be limited at times. Matching systems are
well-suited for trading smaller amounts as well.

The
dealing system characteristics of speed, reliability, and safety are replicated
in the matching systems. In addition, credit lines are automatically managed by
the systems. Traders input the total credit line for each counter party. When
the credit line has been reached, the system automatically disallows dealing
with the particular party by displaying credit restrictions, or shows the trader
only the price made by banks that have open lines of credit. As soon as the
credit line is restored, the system allows the bank to deal again. In the interbank
market, traders deal directly with dealing systems, matching systems, and
brokers in a complementary fashion.

May 6, 2013

Currency
spot trading is the most popular foreign currency instrument around the world,
making up 37 percent of the total activity.

The
fast-paced spot market is not for the faint hearted, as it features high
volatility and quick profits (and losses). A spot deal consists of a bilateral contract
whereby a party delivers a specified amount of a given currency against receipt
of a specified amount of another currency from a counter party based on an
agreed exchange rate, within two business days of the deal date. The exception
is the Canadian dollar, in which the spot delivery is executed next business
day.

The
name "spot" does not mean that the currency exchange occurs the same
business day the deal is executed. Currency transactions that require same-day
delivery are called cash transactions. The two-day spot delivery of currencies
was developed long before technological breakthroughs in information
processing.

This
time period was necessary to check out all transaction details among counterparties.
Although technologically feasible, the contemporary markets did not find it
necessary to reduce the time to make payments. Human errors still occur and
they need to be fixed before delivery. When currency deliveries are made to the
wrong party, fines are imposed. In terms of volume, currencies around the world
are traded mostly against the U.S. dollar, because the U.S. dollar is the
currency of reference.

The
other major currencies are the euro, followed by the Japanese yen, the British
pound, and the Swiss franc. Other currencies with significant spot market
shares are the Canadian dollar and the Australian dollar. In addition, a
significant share of trading takes place in the currency crosses, a non-dollar
instrument whereby foreign currencies are quoted against other foreign
currencies, such as the euro against the Japanese yen.

There
are several reasons for the popularity of currency spot trading. Profits (or
losses) are realized quickly in the spot market, due to market volatility. In
addition, since spot deals mature in only two business days, the time exposure
to credit risk is limited. Turnover in the spot market has been increasing
dramatically, thanks to the combination of inherent profitability and reduced
credit risk. The spot market is characterized by high liquidity and high
volatility. Volatility is the degree to which the price of currency tends to fluctuate
within a certain period of time. Free-floating currencies, such as the euro or
the Japanese yen, tend to be volatile against the U.S. dollar.

In
an active global trading day (24 hours), the euro/dollar exchange rate may
change its value 18,000 times. An exchange rate may "fly" 200 pips in
a matter of seconds if the market gets wind of a significant event. On the other
hand, the exchange rate may remain quite static for extended periods of time,
even in excess of an hour, when one market is almost finished trading and
waiting for the next market to take over. This is a common occurrence toward
the end of the New York trading day. Since California failed in the late 1980s
to provide the link between the New York and Tokyo markets, there is a
technical trading gap between around 4:30 pm and 6 pm EDT. In the United States
spot market, the majority of deals is executed between 8 am and noon, when the
New York and European markets overlap. The activity drops sharply in the
afternoon, over 50 percent in fact, when New York loses the international
trading support. Overnight trading is limited, as very few banks have overnight
desks. Most of the banks send their overnight orders to branches or other banks
that operate in the active time zones.

The
major traders in the spot market are the commercial banks and the investment
banks, followed by hedge funds and corporate customers. In the interbank
market, the majority of the deals is international, reflecting worldwide
exchange rate competition and advanced telecommunication systems. However,
corporate customers tend to focus their foreign exchange activity domestically,
or to trade through foreign banks operating in the same time zone. Although the
hedge funds' and corporate customers' business in foreign exchange has been
growing, banks remain the predominant trading force.

The
bottom line is important in all financial markets, but in currency spot trading
the antes always seem to be higher as a result of the demand from all around
the world. The profit and loss can be either realized or unrealized. The
realized profit and loss is a certain amount of money netted when a position is
closed. The unrealized profit and loss consists of an uncertain amount of money
that an outstanding position would roughly generate if it were closed at the current
rate. The unrealized profit and loss changes continuously in tandem with the
exchange rate.